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To finance the leveraged capitalization, USG had to borrow approximately $2. 5 billion which would come from bank financing. As such, the proposed capitalization would burden the Company with huge amount of debt on its balance sheet (debt at closing would total $3. 1 billion). USG would go from a company that was virtually debt-free to one overburdened by leverage. The Company would increase its corporate debt from $800 million to $3. 1 billion at closing. By the end of 1992, debt was still projected to be above the .
0 billion level. There would be a deficit in shareholder’s equity across the years.
In addition, the plan called for the Company to divest profitable business units and concentrate in core gypsum and ceiling products businesses, reversing its previous strategy of growth by acquisitions. Besides, work force would be reduced and capital expenditures curtailed. Although USG (with optimism) did not expect any adverse effect, since its plants were in excellent condition. However, due to the fact that our analysis included the consideration of the housing market cyclicality, USG would likely not be able to meet its projections mainly because the gypsum market was starting to enter a depressing cycle at that time.
In a worse-case scenario, USG would be hit hard by a depressingly down housing market and that its businesses would substantially be impacted. If USG could not bring in revenues as projected, the Company would likely have difficulty meeting debt payments. To make matters worse, the Company could find no way out but to default on its debt and eventually call for bankruptcy.
Another question relates to the ability of USG to cut costs. Due to the leveraged recapitalization, the Company would incur significant restructuring expenses.
USG indicated that most of it operating savings would come from layoffs and early retirement; however, it is questionable that the Company would be able to control its expenses. There might be little room for further cost reductions because of its prior major restructuring program initiated by the previous CEO. According to study findings, companies that go though defensive leverage recapitalization encounter high rate of financial distress. The high rate of financial distress results mainly from unexpected and adverse macroeconomic and regulatory developments.
Cyclical Gypsum Market In 1988 where this case is set in, the gypsum market was beginning to enter a downward cycle. It was predicted that in 1989 to 1990 the housing market would be at the worst stage since World War II. On a bigger scale, the world’s economy would also be in a recession. The price of wallboard, USG’s primary product, would start to plummet causing the Company difficulty to generate cash flow to cover its interest payments. Based on the cyclicality of USG’s market, the Company would be substantially impacted by the downward cycle.
The Company might violate its bank covenants (discussed below) due to its huge debt responsibility. Covenants USG’s projected total debt at the end of 1988 was $2,453 million. The Company was committed to reduce debt year after year. However, the debt projections, as shown in Exhibit D, did not convince the creditors that the Company had an aggressive debt reduction program. Total debt at the end of 1992 would still stand at a high level of $2,062 million. The Company’s projected bank covenants included the Debt to EBITDA ratio and the EBITDA to Interest ratio.
The Debt to EBITDA ratio in 1988 was projected to be 6.19x, which is considered to be very high as the amount of debt was as much as six times its EBITDA. The ratio was anticipated to gradually improve to 3. 34x in 1992; however, it was still far from the comfort zone. Typically, for companies of the size like USG, the Debt to EBITDA ratio indicates healthy operations when it is below 2. 0x. USG’s projected Debt to EBITDA ratios seemed to have a tight cushion if not already violated. If the Company did not meet its projected cash flow, this bank covenant would be violated. The EBITDA to Interest ratios for the projected period were in the range of 1.72x to 2. 37x.
The projected range indicated that the Company had sizable interest expenses to fulfill. It is crucial that USG had to generate sufficient cash flow to service its debt. If it failed to do so, the Company would default on its loans not being able to satisfy its required interest payments. Since the projected EBITDA to Interest ratios were relatively low, it appeared that USG would unquestionably violate this bank covenant if cash flow was lower than projected. In addition, the above projected covenants were calculated based on management’s projections, which are typically optimistic.
If the projections were to be sensitized (to be conservative), it is believed that USG would violate its bank covenants and default on its loans primarily due to its high debt leverage. Asbestos Litigation There was a going concern problem related to recent USG asbestos lawsuits. In 1987, the Company had been charged a total of close to $1 million in three separate cases. To cover potential liability stemming from future lawsuits, USG purchased additional liability insurance. Management USG’s management team at the time was led by CEO, Robert Day.
Day joined USG in 1950 and held various managerial positions until 1969, when he was elected vice president, marketing, in 1974, senior vice president in 1977, and executive vice president and a member of the board of directors in 1979. Day served as president and chief operating officer from June 1985 to December 1989. He then served as chairman from December 1989 until his retirement in May 1990 after 40 years of service. Even though during 1988, Day directed efforts to thwart a hostile takeover, the question is whether or not his intension was to keep his job rather than maximizing value for shareholders.
In addition, another consideration relates to the discipline of the management team. The Company would essentially be shifted from equity to debt. A heavy debt load could hurt USG’s growth by leading it to focus too relentlessly on short-term cash flow, thereby losing strategic focus. Under the leveraged recapitalization plan, USG would be loaded with debt, which translates that the Company is required to be managed differently than before. It is questionable that the management at USG was capable of managing a highly leveraged company. Recommendation
Based on the presented analysis, USG’s leveraged recapitalization appeared to be worth less than Desert Partners’ offer. If the shareholders voted for the leveraged recapitalization, they would be distributed $37 in cash for each share, plus they would get $5 in junior subordinated debentures and hold one share of the stub equity. However, the values in junior subordinated debentures and the stub equity were not guaranteed. Given the high leverage of the Company after the leveraged recapitalization, the values might be not worth anything.
On the other hand, Desert Partners’ offer was $42 in cash, in line with the value based on the market valuation approach, essentially gave shareholders more value. Some of the concerns that were discussed above included the high leverage of the Company (post-recap), its ability to satisfy debt requirements, and whether or not management was able to manage a highly leveraged company. USG would be loaded with substantial debt on its balance sheet after the closing of its leveraged recapitalization.
With downward housing starts quickly approaching, the demand for gypsum products would significantly decline and thus the Company would financially be impacted. Further, USG had to have cash flow to service its large portion of debt. If the Company were to encounter financial distress, its debt would likely be defaulted which would call for another alternative such as bankruptcy. When comparing USG with other companies in the same industry, its debt to total capital ratio was significantly higher than the peers, with a 57% versus the industry median of 41% and mean of 33. 6%.
In addition, since the USG would be shifted from equity to entirely debt, it would be a different company for management to administer. Despite the fact that USG resisted the tender offer, the question is whether or not management could be able to manage a company fully loaded with debt. As in the situation of the shareholders, the upside of the leveraged recapitalization is that they would still hold an equity stake in USG. However, it is very uncertain that the Company would be able to meet its financial targets and service debt due to the cyclicality of the gypsum industry; the equity stake for the shareholders might not be worth anything.
Moreover, as the creditors’ perspective, it is questionable that if it was worth it to provide financing for USG since the Company posted a substantial risk in terms of not being able to pay back. In the case of USG, their leveraged recapitalization was a response to possible takeover. Typically, successful leveraged recapitalizations should be proactive as part of a long-term program to improve performance rather than defensive in nature. As such, solely for the benefit of the shareholders, it is recommended that the shareholders should tender their shares to get up-front cash from Desert Partners.
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